How to Be Honest Enough to Avoid an IRS Audit

Gene Marks is a columnist, author, and small-business owner. He oversees the Marks Group, a 10-person technology consultancy to small and medium-size businesses. A certified public accountant, Marks has also worked in the entrepreneurial services arm of KPMG. He writes for The Washington Post, Forbes, and The Huffington Post.

As a business owner, the worst nightmare of nightmares is getting an Internal Revenue Service audit. So get ready. Here comes tax season. And here comes the onslaught of tax tips, advice and recommendations for avoiding an audit.

For starters, if you're concerned about an audit, your odds are looking better after Congress's recent budget agreement. According to the House Appropriations Committee, the IRS's funding level would be lower than the agency spent in 2009.

The Tax Man

But don't get too cocky. Because if you earn a decent amount, history is not on your side. According to the IRS, of the nearly 141 million individual returns filed for fiscal year 2011, 1.1 percent were audited. Six percent of the IRS audits conducted on individuals in 2012 were for people who made between $200,000 and $1 million. People with incomes of $200,000 or higher had an audit rate of 3.26%, or one out of every 30 returns. People with $1 million or more of income had a one-in-nine chance of their returns being audited.

So get ready for some well-intentioned advice about how to avoid an audit. Pundits, professionals and experts will tell you to check your figures, because math mistakes are easily found and raise eyebrows.

They'll warn you not to under-report income because the IRS gets the same W-2's and 1099's that you get and its computers check what you report. They'll also encourage you to file electronically--apparently, the error rate for a paper return is 21 percent while the rate for returns filed electronically is 0.5 percent.

"Don’t take large charitable deductions!" your CPA will yell. "We need to be careful how we treat that rental property you have in the mountains and, for God’s sake, make sure not to run those personal expenses through the company accounts."

He'll also say things like "And that car of yours? I know your daughter uses it, too, so we have to be careful how much of it we claim for business." CPAs get into this stuff. It's what we're all about. Fair enough.

Keep an eye on the TV, too. News stations and morning shows will begin trotting out their experts to share their advice. Watch them warn you about how dangerous it is to take a loss from a hobby or get too aggressive with your home office deduction.

Pay attention when they say that the IRS likes to audit cash-intensive small businesses and how the agency is particularly interested in people and companies with foreign bank accounts or who engage in large currency transactions too.

It’s true. It’s relevant. It’s helpful. But admit it. . . if you’re like most business owners, you know where the skeletons lie, don't you? You know that you sometimes dip into petty cash for "office expenses" that really aren't office expenses.

You remember the few times this year where you took a cash payment from a customer and "forgot" to tell your bookkeeper. You know you sneaked through a few extra meals on your last "business trip" with the better half. This is what business owners do. You don't think you're dishonest. You rationalize that these things are relatively immaterial.

But here’s the thing: Maybe you'll get audited. Maybe you won't. There's really very little you can do to avoid it. You might be high risk or not. You can go out of your way to avoid scrutiny but still win (I mean lose) the lottery and get selected for an audit. And that’s what gives the IRS its power. . . and keeps us all honest. Because getting selected for an audit, or even just being asked to provide information to the IRS is scary. Stressful. Distracting. Costly. Time consuming.

So what's truly the best way to avoid an audit? "Just expect it," Andrew, a client and long term business owner, told me once. "I’m always prepared for it." Why, I ask him? "Because,” he said. “I can sleep better knowing that it will one day happen.” Andrew keeps pretty good records and files. He’s more organized than the average bear. He knows his numbers pretty well and looks through his financials monthly. He's guilty of some minor shenanigans ("Who’s going to know that I overpaid my kid a little?") but not too much.

Of course, he'll never do something significant that's outright illegal, fraudulent or indefensible. It's just not worth it.

Most importantly, Andrew knows his exposures. He knows where he's being aggressive with his inventory write-offs and where the line is for those contractors who could be employees. But he thinks these through and has a good, documented, thought-out basis for why he took the tax position that he did and he's made sure that to have it vetted by his CPA.

And, critically, he's consistent. He can always defend himself by saying he’s done things the same way. And it's a pretty good defense, even if the way he's doing things is arguable.

When it comes to taxes, smart-business owners like Andrew minimize their risks. But surprises can't always be avoided. So he prepares. He has a plan for when something goes bad. Or when the IRS calls. Because no one can avoid an IRS audit. But we can make sure we're prepared.